The equity bounce as mean reversion kicks in

With tighter financial conditions and the US February inflation report showing that the US services core inflation remains at 7.3% annualised our view is that investors should consider their exposure to small caps. This segment has a higher debt leverage to operating income compared to S&P 500 and it is have a lower EBITDA margin meaning that smaller companies have less pricing power amid inflation. The higher debt leverage also means that tighter financial conditions will hit smaller companies more.

Private equity leverage on the rise

Listed private equity firms have been hit hard during the SVB Financial fallout as all pockets of the financial system got repriced lower. It is clear that the venture capital system experienced a dramatic blow and it will just reinforce dynamics that were already taken place, that venture capital funding is drying up. This will force venture capital firms to restrict the new lower funding flows to their best and largest positions. The long tail of venture capital backed companies will have to do it alone to a larger degree which means cutting costs. Overall, the discount rate for venture capital firms has also gone up which means demands of faster profitability by the companies they invest into. All this points to a less aggressive startup ecosystem for the time being and less investments.

The private equity industry has a less uncertain funding situation as many of the private equity owned companies are cash flow positive and thus the sources of funding are more diversified for private equity firms. But many private equity funds have moved into real estate investments, alternatives such as renewable energy projects, private direct loans competing with banks,  their own venture capital investments, and generally been part of a cycle of higher equity valuations on private companies. In many ways private equity firms are a secondary or shadow banking system. The leverage among private equity firms has risen substantially the past year so that the asset-to-equity ratio is ~3x compared to ~2.1x before the pandemic and ~1.8x in 2013.